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5 Reasons You Shouldn't Buy Marijuana Stocks

Marijuana stocks are hot right now. But they might not always be.

You're probably reading this because you want to buy marijuana stocks or have already done so. And you could be second-guessing your decision and want to better understand the risks. Or perhaps you're convinced that buying marijuana stocks is a great idea and want to debunk what anyone says against buying them. Or maybe you're in the opposite camp -- against buying marijuana stocks and want to find support for your stance. I totally understand all three of these views.

The reality is that there are legitimate reasons you shouldn't buy marijuana stocks. Some of these reasons don't apply to every investor, but some of them do. Here are what I consider to be the top five reasons against buying marijuana stocks.

Image source: Getty Images.

1. You're opposed to buying "sin stocks"

If you're opposed to stocks of companies that sell products that could be harmful to people, marijuana stocks might not be for you. However, it's not as clear cut as it might seem.

Two types of sin stocks that some investors avoid are alcohol stocks and tobacco stocks. Drunk driving claims more than 10,000 lives each year. Smoking tobacco cigarettes causes one out of every five deaths in the U.S. each year. Both alcohol and tobacco are addictive. These criteria are enough for many investors to swear off buying stocks in the industries.

What about marijuana? Like alcohol, marijuana is mind-altering and can be a factor in driving-related fatalities. And like both alcohol and tobacco, it can be addictive for some people. These facts could be enough for some investors to swear off marijuana stocks completely.

However, marijuana also can be used medically. Some marijuana stocks are associated with companies that are focused exclusively on therapeutic use of the drug. GW Pharmaceuticals(NASDAQ:GWPH), for example, is waiting on U.S. regulatory approval for Epidiolex, a cannabinoid that holds significant potential for helping treat patients with two rare forms of epilepsy. Epidiolex is made from cannabinidiol (CBD), a chemical in marijuana that isn't addictive or mind-altering.

Personal opposition to buying sin stocks, therefore, might be a valid reason against buying many marijuana stocks -- but not all of them.

Image source: Getty Images.

2. Marijuana remains illegal in the U.S. at the federal level

There's a solid case to be made against buying marijuana stocks with significant operations in the United States. Even though nine states plus the District of Columbia have legalized use of recreational marijuana and 29 states and D.C. allow medical marijuana, federal laws still prohibit the drug.

It's entirely possible that the U.S. government will crack down on the marijuana industry. U.S. Attorney General Jeff Sessions recently reversed policies from the Obama administration that essentially left states alone to do their own thing with regard to enforcement of marijuana laws. His move underscored just how risky marijuana stocks with U.S. ties can be.

Aphria(NASDAQOTH:APHQF) ran into another problem relating to U.S. federal laws. The Canadian medical marijuana grower had expanded into the U.S. last year and was planning to increase its U.S. presence. However, the Toronto Stock Exchange, on which Aphria stock trades, hinted at delisting any stock "with ongoing business activities that violate U.S. federal law regarding marijuana." As a result, Aphria began to reduce its exposure to the U.S.

Of course, there are quite a few marijuana stocks with little to no ties to the U.S. for which this isn't an issue. Canopy Growth(NASDAQOTH:TWMJF), for example, is the largest medical marijuana grower in Canada. The company applauded the actions by the Toronto Stock Exchange, with Canopy CEO Bruce Linton committing to only operate "in jurisdictions where it is federally legal to do so."

3. Valuations are sky high

There's no getting around that the valuations of most marijuana stocks are astronomically high. Most of the companies aren't profitable yet, but their stocks trade at steep price-to-sales multiples.

Just look at the three marijuana stocks already mentioned. Aphria shares trade at 98 times trailing-12-month sales. Canopy Growth's price-to-sales multiple is nearly 92. GW Pharmaceuticals trades at a whopping 315 times sales. If you don't like stocks with hefty valuations, stay away from marijuana stocks.

Keep in mind, however, that valuing stocks can be tricky. That's especially true where the potential market could increase tremendously. The Canadian marijuana market is projected to be worth between $4.2 billion and $8.7 billion annually -- and possibly much higher. If those estimates are right, Aphria and Canopy Growth stocks might not be so overvalued right now, assuming the companies can grab a big enough chunk of the market.

Image source: Getty Images.

As for GW Pharmaceuticals, some analysts think that Epidiolex could generate peak annual sales of more than $2 billion. With GW's market cap currently around $3.7 billion, the biotech doesn't look terribly expensive, assuming those sales estimates aren't too far off.

It all comes down to estimates and projections, though. If you're skeptical about the size of the Canadian marijuana market or potential sales of marijuana-based drugs like Epidiolex, you'll probably want to avoid buying marijuana stocks.

4. Dilution is rampant

In my view, one of the biggest things to worry about with marijuana stocks is the potential that rampant dilution could take its toll. Aphria and Canopy Growth have made several bought deal financing transactions over the last 12 months. Canadian companies use these deals to raise cash, with an investment bank or syndicate agreeing to buy all securities to be issued at a predetermined price.

Aurora Cannabis(NASDAQOTH:ACBFF) is one marijuana grower that issued convertible debentures through bought deal financing. These convertible debentures start off as a loan but can later be converted into stock. It's possible that those conversions occur down the road at an inopportune time, causing Aurora stock to take a big hit.

So far, though, the dilution from these transactions hasn't appeared to weigh down Canadian marijuana stocks. Maybe concerns about the issue turn out to be overblown. But it's a fact that issuing more stock makes existing stock less valuable. For some investors, this is a potential looming problem that will remove many marijuana stocks from serious consideration.

5. Commoditization is coming

Like it or not, marijuana is a commodity. It's great right now for marijuana stocks like Aphria, Aurora, and Canopy, with demand much greater than supply. That situation won't last indefinitely, though. The time will come when commoditization is a serious worry for many marijuana stocks.

Some companies will be able to navigate the impact of commoditization by establishing brands with enduring appeal. Many of the Canadian marijuana growers are already making efforts to build their brands. There's no guarantee that they'll be successful over the long run, though. And it's possible that other companies could enter the market -- for example, big tobacco companies -- and steamroll existing players.

Biotechs like GW Pharmaceuticals are in a different boat. They enjoy protection from competition, at least for a while, thanks to patent exclusivity. However, if the biotechs aren't able to win enough patent approvals, their long-term prospects could be diminished.

If you don't feel you know who the winners will be in a highly commoditized market, you might not want to buy Canadian marijuana stocks. And if you're skeptical about the ability of biotechs such as GW Pharmaceuticals to secure substantial intellectual property protection, those stocks could be a poor fit for you.

Cannabis caveats

You probably noticed that I hemmed and hawed to some extent on every argument against buying marijuana stocks. Each reason for not buying marijuana stocks has its caveats. That's the appropriate word, because the original meaning of "caveat" means "let a person be aware."

So if you're wanting to buy marijuana stocks or already have done so, be aware of the risks -- including potential enforcement of federal laws in the U.S., a bursting bubble from sky-high valuations, the impact of dilution, and the threats of commoditization. If you're dead set against marijuana stocks, be aware that some of them just might present reasonable investment alternatives for you. Being aware of the pros and cons of any individual stock or group of stocks will make you a better investor.

Keith Speights has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

Author

Keith began writing for the Fool in 2012 and focuses primarily on healthcare investing topics. His background includes serving in management and consulting for the healthcare technology, health insurance, medical device, and pharmacy benefits management industries.
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